Capital Model

Overview

The capital model determines the minimum amount of funds the mutual needs to hold. Nexus Mutual uses actuarial mathematics derived from the Solvency II methodology as developed by the European Insurance and Occupational Pensions Authority ("EIOPA") to set its Minimum Capital Requirement ("MCR").
There are two main components making up the MCR calculation:
  1. 1.
    The Best Estimate Liability (or “BEL”), representing the expected loss on each individual cover.
  2. 2.
    A Buffer, representing the funds the pool requires to survive a 'black swan' event.
Similarly to a traditional insurance entity, Nexus Mutual will hold (and invest) a Capital Pool of assets in excess of the MCR in order to back its covers (see Assets and Investment). The ratio between the Capital Pool and the MCR is known as the coverage ratio and abbreviated to MCR%.
Note that the MCR is subject to a lower limit below which it cannot fall. This level was set at 7000 ETH but is now dynamic given by MCR_floor.

Best Estimate Liability

The BEL will initially be equal to the total Risk Cost across all active covers on the mutual's books.
In the future, as we begin to gather experience on the outcomes of covers, we will be able to create a more accurate BEL which also allows for the remaining duration on each individual cover. Currently, the BEL for each cover represents the entire Risk Cost regardless of remaining duration - a prudent assumption resulting in higher reserves required per cover.

Buffer

The Buffer represents the funds that Nexus Mutual will hold, in addition to the BEL, in order to protect itself against unforeseen adverse events. The intention (with no obligation) is to follow the Solvency II framework and calibrate this amount of funds to a level where the mutual can survive a 1-in-200-year adverse event. In practice, due to the uniqueness of the Protocol Cover and Custody Cover products, some deviations from the SII texts are initially necessary.

Smart Contract Cover Module

The Smart Contract Cover Module is based on the exposures Nexus Mutual has to the covers it has written. The inputs to the model are:
  1. 1.
    Total Cover Amounts CA(i) for each individual protocol and custodian
  2. 2.
    Correlations Corr(i,j) between each pair of contracts.
  3. 3.
    Scaling Factor SC which is calibrated to make the capital result as a whole more comparable to a full Solvency II calculation.
The correlations between each pair of two contracts are established by parsing the respective verified smart contract code, removing comments and spacing, and establishing the proportion of identical text.
These inputs are fed into the following formula to produce a Capital Requirement CR across all covered contracts within Protocol Cover and Custody Cover:
CRSCC=SC×i,jCorr(i,j)×CA(i)×CA(j)CR_{SCC} = SC \times \sqrt{\sum_{i,j} Corr(i, j) \times CA(i) \times CA(j)}

Currency Module

The currency module allows for possible fluctuations in the value of other currencies (initially only DAI) relative to the value of the base currency (ETH).
50% stresses in both directions are applied to the value of the other currencies in order to establish the impact on both the assets and the buffer requirement of the mutual.

Final MCR as per Capital Model

The Currency Module scenario with the lowest resulting MCR% coverage (across both the BEL and the Buffer) is picked out. This MCR% coverage is then applied to the Capital Pool in order to inform the choice of Gearing Factor.